Updated 03 December 2020
What is IR35 and how can you avoid being caught out by it? We explain what this controversial tax change means for contractors and the businesses that hire them, and how to take steps to reduce the risk of being sunk by the IR35 trap. Article by Nick Green.
Small businesses and freelancers alike have been bracing themselves for an imminent change in a piece of tax-avoidance legislation. This has been pushed back thanks to the coronavirus, but it still means that from April 2021 private sector employers will have to follow the same rules as the public sector with regard to IR35. The Federation of Small Businesses has warned that both companies and contractors will feel the pinch.
IR35 is also known as the ‘off-payroll working rules’. IR35 is designed to prevent workers from avoiding tax by operating as contractors, when really they are employees in all but name. So for example, if a contractor operates via their own limited company, but is otherwise treated the same as their client's employees, they are considered to be 'inside IR35' and will need to make additional tax payments.
IR35 was originally introduced by Gordon Brown, to prevent employees from avoiding tax by being treated as contractors. However, since then the legislation has become notorious, sometimes implicating businesses that believed they were hiring contractors appropriately, only for HMRC to disagree.
Post-April 2021, private sector employers will be held responsible for determining whether IR35 applies to any contractor they hire – which would require them to treat the contractor as an employee for tax purposes. This is already the case in the public sector.
Private sector businesses will therefore face a tricky choice: continue to treat contractors as contractors and risk a hefty fine if HMRC takes a different view – or treat them as employees with the additional costs and responsibilities this involves. There is widespread concern that genuine contractors will be classed as employees, and so will either take an unfair tax hit, or lose their contracts altogether.
IR35 was introduced because of the way employees are treated differently from contractors. With an employee, an employer must provide a workplace pension, paid holiday, sick pay, other benefits (perhaps) and pay employer’s National Insurance contributions. A contractor, on the other hand, is paid a flat fee and can be dismissed easily if there is no more work for them to do.
The vast majority of contractors operate as limited companies, either one-person companies or ‘umbrella’ companies. It’s rare for contractors to be sole traders, as unlimited liability make this risky for them, while companies are wary of hiring them in case HMRC thinks they are employees. Operating as a company also means the contractor can pay less tax.
However, operating as a company doesn’t prevent a contractor from being an employee in all but name – which is where IR35 comes in. Broadly, IR35 says, ‘If it looks like a duck and quacks like a duck, it’s a duck.’ In other words, if the contractor is working like an employee, with similar obligations, then they should be treated as one for tax purposes. HMRC therefore looks very closely at what it calls ‘personal service companies’.
Though the name may sound dubious, a personal service company (PSC) is merely a company through which a contractor operates in order to do their freelance work (because most businesses won’t hire a sole trader). The term isn’t defined in law – HMRC simply uses this label to describe companies that may be used as ‘cover’ by contractors who are really employees in all but name.
This creates a double problem, affecting both contractors and the businesses that want to use them. If a business is afraid that any contractor it hires might be considered an employee by HMRC, it may not risk hiring them at all. In this case, both the business and the contractor lose out. This is what many small business fear will happen post-April 2021.
HMRC offers an online tool, Check Employment Status for Tax (CEST) that you can use to give yourself a general guide to your status. However, industry bodies (including IPSE, the Association of Independent Professionals and the Self-Employed) fear it is still not fit for purpose. Contractors, recruitment agencies and end-clients therefore shouldn't rely on it wholly when determining IR35 status.
One of the key deficiencies of the CEST tool is that it does not factor in 'Mutuality of Obligation' (MoO). Mutuality of Obligation is one of the defining characteristics of employment, in that the employee has certain obligations towards the employer, and vice versa. Many of these obligations do not apply to contractors (e.g. the contractor can choose where and how to deliver the work, and can delegate it to an associate if necessary; while the client is not obliged to offer the contractor more work). MoO has been a decisive factor in a number of recent IR35 tribunals, which is another reason why the CEST tool is still only a rough guide.
Fears that the changes to IR35 will spell the death of freelancing are exaggerated. By taking the appropriate steps, both contractors and businesses can ensure that they do not fall foul of IR35.
Remember, IR35 is something that applies to a role, rather than an individual. So just because you were outside it on your last assignment, doesn't mean that you won't be inside it on your next one. For every assignment that you take on as a contractor, the most important thing is to be able to show that you are ‘in business on your own account’ and therefore not an employee.
If you are a contractor operating through a limited company (either your own or an umbrella company), HMRC may ask for evidence that you are genuinely freelance, and not just an employee of your client. Here are some ways that you could make your case.
Genuine employees will have certain set working conditions, such as minimum hours, pension arrangements and other benefits, and perhaps subsidised services too. The employer also has a duty to provide work for them, which the employee has an obligation to do – and the employer can stipulate where and how the work is to be carried out. You should be able to show that little if any of this applies to you.
If you have emails that clearly state you are not under the control of a manager at the business, but are simply contracted to provide a service, this can be useful too.
HMRC knows that a company named after a person may well be just that person, and this fits their profile of a PSC. But if your company has a more ‘business-like’ name, e.g. XYZ Design, it emphasises the fact that your company is distinct from you, and that you could delegate the work to another person if necessary. Employees cannot delegate in this way, so it marks you out as different.
You should be able to demonstrate that you market your contracting services actively. Have a listing on relevant services website, post adverts and print business cards, all of which help to indicate that you are in business on your own account. Never use a business card which includes your client’s branding!
A well-equipped office, even just in your own home, will strongly imply that your work activities extend well beyond your current client. If you also invest in your own software licences, trade literature and professional memberships, this can help a great deal too.
Having your own business insurance, such as professional indemnity insurance, is a great way of demonstrating that you’re not just an employee.
Employees don’t pay for their own training, so if you pay for yours this will be another useful point of difference. Some professions may require you to take continued professional development (CPD) to remain qualified, so by paying for this you’re also reasserting your contractor status.
It’s not always possible to arrange, but if your time is split fairly evenly between two or more main clients, it’s much harder for HMRC to claim you’re an employee of any of them. However, having a very uneven split (e.g. 90 per cent of your income deriving from one client) may be less convincing.
The more of these strands of evidence you can call upon, the more likely it is that HMRC will accept you are in business on your own account. Having just one or two on their own may not be enough.
If your business hires contractors, either from time to time or on an ongoing basis, then you should review your relationships with them to ensure they don’t fall inside IR35.
From April 2021 it will be your responsibility to determine whether a worker is an employee or a contractor for tax purposes. You will have to issue a Status Determination Statement to your contractors, which makes their IR35 status clear (inside or outside the rules) and explains why. As long as you support your decision with sufficient evidence and file the appropriate tax documents, you should avoid any penalties.
In summary, you should:
Some contractors who fall within IR35 and are treated as employees for tax purposes may feel they are entitled to full employment status, with all the protections that go with it. There are many potential issues that can arise from this, such as claims for backdated holiday pay, which will have to be addressed on a case-by-case basis.
Ask your accountant to help you face up to IR35 with confidence.